The Federal Reserve deliberated on its monetary policy after the shocking decision by Britain to leave the European Union last month. The overtone of the July 2016 FOMC meeting was bullish. The Fed wasn’t too concerned about the possible fallout of Brexit and we can attribute this to the smooth transition of power from David Cameron to Theresa May.
For now, the world operates on the assumption that May has a game plan for an orderly exit of Britain that would take two years once it triggers Article 50 of the Lisbon Treaty. In other words, Brexit is now a medium-term concern, and the EU did not disintegrate as feared earlier.
Focus on recovering economy
This changes the primary concern of the Fed back to the domestic economy. This is clear in the following quote from the July FOMC:
“Near-term risks to the economic outlook have diminished.”
First of all, the Fed acknowledged the strong and persistent recovery of the U.S. economy. The strong labor market recovery continued, and this has helped to lift the spending of the U.S. consumer, which accounts for 70% of the economy.
Source: TradingEconomics
The chart above shows the twin recovery of the labor market and consumer spending over the past five years. The unemployment rate stands at 4.9% today compared to 9% five years back and average hourly wage rose from $19.50 in 2012 to $21.50 today. The Conference Board reported broad-based improvement in consumer confidence.
Addressing the inflation concern
The only economic indicator that is stopping the Fed from raising rates would be the low inflation environment. The current inflation rate is 1%, and this is still far from the 2% target.
Source: Trading Economics
After oil prices fell off the cliff in the second half of 2014, the Fed and most analysts expected it to bottom out in early 2015. It turned out that they were early by one year. In any case, oil bottomed out in January, and inflation bottomed out in September 2015.
As inflation measures the rate of change in prices, even if oil prices were to stabilize in the $40 to $50 range, inflation would recover with the improving economy and trend of higher wages. Given the lag in monetary policy, the Fed would be likely to raise interest rates in advance.
Winners in higher interest rate environment
The banking sector would be one of the main beneficiaries of the normalization of interest rates.
The sector's members earn their incomes from the difference between the cost of funds given to depositors and the interest they charge their lenders. Their depositors can range from a small wine retailer to major corporations.
When interest rates rise, they can charge their lenders more but hold off the increase for their depositors. After all, they are providing a safe place for money to be withdrawn at short notice. Bank of America (BAC, Financial) is one such beneficiary, and an online search produced the following helpful chart.
Source: Motley Fool
Of its $82.8 billion income last year, it derived 48.6% of it from net interest income alone. This is their bread and butter which provides a steady income over more glamorous activities such as investment banking and trading.
The better economic environment will also help other divisions earn higher incomes as companies become more active in seizing opportunities. A rising tide lifts all boats and the net interest income would probably lead in the recovery.
That said, Bank of America has to be careful of the threats from the fintech sector which is competing for its deposit base. Small and medium enterprise (SMEs) favor these fintech setups such as Funding Circle for their loans. SME loans are the foundation for the net interest income as the 30 million SMEs are the backbone of the U.S. economy.
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